What are TIPS?

Straight from the Treasury… “The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” 

Simple concept, and seemingly helpful to protect investor spending power, but does the Consumer Price Index accurately reflect the true change in prices?

Consumer Price Index (CPI)

From the Bureau of Labor Statistics… “The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.”

Lot to unpack, but here’s a breakdown of the weights within the CPI calculation.

Source: Strategas. As of February 2021

Much attention is often given to the housing component since it makes up more than 40% of the overall index which is based on a “rental equivalency approach”. This essentially measures what someone would pay to rent their home today, not changes in the cost to buy it.

Remember, assets are intentionally omitted from the calculation, making CPI a poor proxy to measure asset inflation, specifically in this case accounting for the rise in housing prices. However, transportation and food & beverage make up just shy of 1/3 of the index, and both the transportation and food categories are pointing to higher prices.

We believe the CPI calculations of housing likely depresses the overall CPI number given its weight and also the systemic challenges created in the housing market where house prices are quickly rising across many areas of the United States. At the same time, rents are being depressed due to government-mandated rent memorandums and the exodus of people from large cities.

Given that information, is CPI an accurate gauge of inflation?  Also, if the Fed’s mandate to control inflation matters to them, would a measure of inflation that may undershoot actual inflation be beneficial towards that mandate?

TIPS & Breakeven Rates

Inflation expectations measured by the Breakeven Inflation Rate, indicates investors’ perception of how future inflation will translate into pricing decisions. Breakeven rates are measured by the spread between the yields on US Treasury bonds and on TIPs. For example – if the 10 year treasury is at 1.50% and TIPS current yield is -0.80% (yes that’s a negative number), the breakeven rate would be calculated by subtracting a negative 0.80% from 1.50% to give you 2.30%.

Source: Fed Reserve Bank of St. Louis, As of March 8, 2021

Currently, the market is forecasting that U.S. inflation will run at 2.43% over the next five years, the highest rate of market-predicted inflation since the 5-year breakeven rate hit 2.63% on July 7, 2008.

Breakevens continue to trend higher, where the market is pricing in a likelihood of higher inflation to come, especially in the nearer term. A rise in interest rates and inflation expectations lead to concerns of how equity markets will digest the changing environment and in turn, how will the Fed will respond. While we believe near-term inflation is likely, we think inflation is likely to be more short-lived as the economy reopens.

Where this Gets Fishy

Breakeven Rates can be decomposed into 2 things:

1. Pure inflation expectations
2. An inflation risk premium (premium for uncertainty).

Both characteristics have attributed to the rather large rise in inflation expectations since March 2020. We believe that the inflation risk premium has likely been overstated due to removal of supply within the TIPS market.

Central Bank Asset Purchases Likely Skewed Breakeven Rates

Notice the 3rd chart below. The outstanding amount of TIPS declined dramatically because the Fed bought more TIPS than they issued. To put into perspective, the Fed bought about 35% more of the supply of TIPS than the Treasury issued (~$190bn bought vs ~$140bn issued). The combination of higher supply of Treasuries and lower supply of TIPS likely contributed to the higher measured risk premium.

Source: Bloomberg. As of March 1, 2021

To go further, we believe the run up in TIPS was likely further exacerbated given the macro and policy backdrop where investors flocked to TIPS for protection against potential inflation, all things together contributed to a rise in breakeven rates. Econ 101, less supply with higher demand raises prices and reduces yields impacting the breakeven calculations from above.

Yields Have Risen… Although it is Mostly Normal

We believe the recent rise in interest rates from the August lows is a normalization of interest rates that can be equated to healthy factors occurring in a recovering economy. We continue to see strong evidence supporting normalization such as strong global reflation, vaccine deployment (i.e. herd immunity), strong household balance sheets thanks to government support, and wide spread pent-up demand from a reopened economy.

Source: Bloomberg. As of March 8, 2021

The $1.9bn stimulus package working its way through Washington and the $2 trillion in cash on the sidelines likely further support more reflation and cyclical outperformance as the yield curve normalizes (i.e. Steeper Yield Curve). Bottom line, if inflation is pushing nominal growth higher, any attempt by the Fed to suppress interest rates is likely to be rejected by the bond market.

Buyer Beware

We would argue that tying up a significant portion of your portfolio to an index that is, in our opinion, debatably undershooting real inflation could lead to outcomes substantially worse than you expect as the investor. Since the end of ‘08 following the GFC and quantitative easing programs, CPI has averaged just 1.5% per year. Meanwhile, we’ve all experienced substantially higher inflation when considering cost of education, healthcare, insurance on top of the big one… inflation in asset prices (i.e. bonds, stocks, real estate, hard assets, etc).

When considering that the basket used for measuring inflation could be an imperfect metric, it’s worth considering if any security whose price is related to this metric is worth depending on to drive returns.

It’s our opinion that the CPI is a bad measure for inflation and the TIPS market in general is reliant (manipulated may be more appropriate) on a single player…the Fed. As you can see in the charts above, they own over 20% of the entire market.

To quote a recent blog post on the current backdrop regarding pricing within the TIP market:

“Of course, no one is cheering for strongly higher future inflation, but a strongly higher inflation breakeven rate does indicate that TIPS overall are starting to get “pricey” versus nominal Treasuries. An inflation breakeven rate over 2.5% is expensive for the TIPS investor. Historically, TIPS have usually under-perform nominal Treasuries when inflation expectations get very high, as investors anticipation of higher inflation doesn’t come to fruition.”  (Paraphrased. Source: https://tipswatch.com/)

As investors are faced with the need for assets that can diversify equity risk while also protecting against higher inflation (bonds cannot), we’d champion long volatility strategies over TIPs. Things to think about when wading in the TIPS water.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary contains information and links to third party sites not affiliated with Aptus Capital Advisors (“ACA”). This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2103-7.

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But it seems investors are piling in with little regard for price, even with tax-equivalent yields lower than their Treasury counterparts. The rich pricing can likely be attributed to a limited supply of bonds as state and local governments have received significant government funding on top of record tax inflows from increasing property values.

And we’re not alone; Bloomberg’s Muni Bonds Are the King of Costly cites the raging inflows and extreme muni-Treasury ratios as danger signs. One chart from that piece below:

Source: Bloomberg (as of 2/22/21)

Simply put, these groups are flush with cash with even more stimulus on the horizon as Biden’s $1.9bn stimulus plan is substantially front-loaded. As new issuance has temporarily decreased, investors are working with limited supply and in turn bidding up prices.

     Projections via Strategas (As of 2/23/2021)

While we’ve generally encouraged high tax bracket investors to look to municipal bonds as anchor positions, the value prop from here looks limited. Even given the higher probability of higher tax rates for both individuals and corporations under a Democratic government, we’re no longer sure the math adds up and we expect spread to Treasuries to normalize.

Historically, the muni space has shaken investors with painful reversals when trends are overdone, as seen following the 2016 presidential election and after the Puerto Rico credit crisis in 2013. We’d tread carefully in municipals as this plays out.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

Projections or other forward looking statements regarding future financial performance of markets are only predictions and actual events or results may differ materially.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2102-15.

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Source: Bloomberg, as of 2.17.21

Adding convertibles to allocations during times of market turmoil can position investors to clip income and potentially capture equity market upside as the market recovers, while also incorporating minimized downside. But with convertibles specifically…context, valuation and timing are everything.

Right now, given the backdrop of the convertible sector from a pricing perspective, we believe investors utilizing convertibles exposures in their portfolios, specifically in lieu of traditional fixed income, could be injecting significant risk into their clients’ portfolio.

Read here for a breakdown of the risks and (lack of) rewards in today’s convertible market.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2102-10.

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Source: Bloomberg as of 11.27.2020   

Lower for Longer… and Longer

With the Fed adamant on keeping interest rates at 0% for the foreseeable future, investors are being forced to reach for yield. Per the Fed Dot Plot below, the first inkling of a rate hike isn’t until 2022.

 Source: Bloomberg (Fed Dot Plot) as of 11.30.2022

With that in mind, investors have a limited set of options to provide historically acceptable yields without adjusting risk or liquidity constraints. How we’ve seen investors adapt to the yield environment is a bit concerning.

So Where Does That Leave Us?

High Yield spreads as measured below by the Barclays US-Corporate High Yield Bond Index have contracted back near pre-COVID-19 levels. With yields compressing significantly from the March selloff, we caution investors to also consider the companies that utilize the high yield market for funding.                                                            

Source: Bloomberg, Aptus Research as of 11.30.2020

While this statement doesn’t comprise all companies that issue HY debt, we’d argue that a significant amount of HY borrowers have seen significant headwinds to their businesses. This could prove to be painful in the future, especially if the recovery takes longer to play out.

Current Yield as a Barometer For Future Returns

We know that current yields give us a decent indicator of what future returns will be. With current yields in the HY space tightening to near pre-virus lows, we believe that future returns could be less attractive than what investors have experienced historically.

 Source: Compound/ Charlie Bilello as of 11.30.2020

This all while having increased risk, with less cushion from high current yield while lending to arguably weaker companies.

Sometimes It Just Doesn’t Make Sense

Now, let’s put the rubber to the road with an example. Just two weeks ago, Carnival Cruise Lines (CCL), one of the hardest hit companies from Covid-19, issued a 7.625% six-year bond deal that was over 5.5x oversubscribed! The kicker here, the bonds are not pledged to any of the assets, i.e., cruise ships. This deal follows over $9bn raised from debt/loans earlier this year and multiple equity raises to help keep the company afloat.

The Windshield View

While we obviously can’t see the future, we do know that current yields offer a look at forward returns. While the market fears have abated since March, the implications of Fed and government action have largely driven the recovery in the high yield space. Given what we believe to be a lack of further catalyst, we see the high-yield asset class as offering one of the worst rewards to risks we’ve ever seen.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.  This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible. Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-2011-32.

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The Fed’s Job

The Fed’s congressional mandate is to maximize employment and price stability over the years ahead in service to the American people. This mandate creates what we consider to be a moving target on an inexact science created from an ever complicated, ever evolving global economy. We believe the Fed must remain fluid in their implementation of policy as the economy changes and new challenges arise.

Our problems today are far different than the conditions forty years ago where the economy faced extremely high inflation (stagflation) and Fed Chair Paul Volcker took drastic action to stabilize inflation to a more normal level. The monetary policies implemented by Volcker led to a relatively long period of economic stability (Great Moderation).

As the economy has morphed over time, long expansions that historically led to overheating and rising inflation have changed to episodes of financial instability and more government intervention to shore up the resilience of the financial system. As the Fed has adapted new policies to face an ever-changing economy, they have attempted to lay out a transparent inflation goal as the primary objective of their monetary policy.

Bringing Full Circle: Inflation Targeting and Implications

This week we got an update from the Fed Symposium in Jackson Hole by Fed Chair Jay Powell, where he emphasized the importance of maintaining a sufficient level of inflation of 2% over a full cycle. As inflation measured by the Fed has been below the 2% threshold even with record unemployment and a robust economy (pre-Covid), the Fed will likely seek to achieve inflation moderately ABOVE 2% for some time. One important takeaway…the Fed essentially stated they are abandoning one of their tools, the Phillips curve, as the responsiveness of inflation to labor market tightness has contributed to low inflation outcomes, contrary to previous beliefs.

This policy measure is to avoid the chain reaction of chronically low inflation which has led to the lower interest rates environment and in turn decreased the effectiveness of the Fed’s ability to use their monetary policy tools to achieve their mandate and spur the economy during downturns. We believe this is what the market is referring to when we hear the Fed is out of ammunition and it appears the Fed is trying to get in front of the issue. This is uncharted waters, so we are likely along for a bumpy ride.

To the Important stuff: Portfolio Considerations

We believe an important driver of both near and long-term market performance is the guidance laid out by the Fed. With Chairman Powell indicating moderately higher than average inflation for some time, we believe the implications of letting the reins go on inflation could validate the valuation of equities when compared to bonds.

As inflation woes work their way through the market, we believe we could see pressure on long duration bonds as investors fear returns on bonds (after incorporating the effects of inflation) could be negative. We will leave you with this, from a historical perspective, bond yields have NEVER been this low which when paired with a potentially inflationary environment creates a unique environment that requires an outside the box approach.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. More information about the advisor, and  its investment strategies and objectives, is included in the firm’s Form ADV, which can be obtained, at no charge, by calling (251) 517‐7198. ACA-2008-37.

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We’ve noticed a trend of under-performance in conservative risk model performance vs. their benchmarks, highlighted during the March lows. BlackRock did a study on how advisor portfolios performed during the pandemic lows and really hit home with what we saw… advisors’ portfolios on the lower end of the risk spectrum drastically underperformed their benchmarks, especially when compared to more aggressive allocations. The poor performance for conservative portfolios from 2/20 – 3/23 showed that the stretch for yield and loosened credit parameters injected considerable equity-like risk into portfolios.

 Source: Blackrock (as of 3/31/20)

The Backdrop:

Given the seemingly never-ending bull market in bonds, allocations have shifted from holding long-term government bonds to lower duration / higher credit risk securities to fill the income gap. The last several years this allocation shift has worked great, as most all fixed income sectors have profited from both falling interest rates and tighter credit spreads. At the depths of the pandemic outbreak, we saw a massive repricing in credit, severely impairing prices of credit securities (remember LQD was down >20%) and brought to light some ugly realities of portfolio construction.

This brings us to our question: what is the point of owning fixed income in the portfolio: diversification, income, or stability?

In the not so distant history, we believe all three could be accomplished with government bonds. Not the case anymore! In a Financial Times (FT) article written earlier this week, we believe they laid out the current fixed income environment quite well.

FT discussed how the reach for yield is getting harder, forcing investors to move ever further out the risk curve. It noted that a record ~86% of the $60T global bond market tracked by ICE Data Services traded with yields no higher than 2% as of June 30. The article also added that more than 60% of the market yielded less than 1%. In addition, just 3% of the investible bond universe currently yields more than 5%, a share that is close to a record low and represents a meaningful drop from the late 1990s when nearly 75% of bonds traded with yields above 5%.

Back to the point… diversification, income or stability?

Based on the metrics, we think it’s obvious advisors have bypassed diversification for income. The move from long-term government bonds to higher-yield allocations has led to a rise in credit risk and in turn greater exposure to drawdowns. As allocations shifted away from government bonds (duration exposure) to higher current income (credit exposure), we question the benefit of holding a bond allocation given significant volatility risk.

The rate environment has forced advisors to choose what they believe to be the lessor of two evils between diversification and income (cash might cover “stability” but zero return seems a high price to pay). We continue to ask ourselves…do we want to own an asset class that exposes us to substantial interest-rate risk? With little to no current income in hopes of price appreciation in a down equity market?

The numbers below run a few conceptual scenarios on 10yr Treasuries using basic bond math…you be the judge on the reward for risk. On the other end of the bond spectrum, we believe stretching for income injects significant volatility into portfolios and does little to weather bad equity market environments, as shown during the March selloff.

Source: Aptus Research / Bloomberg LP.

Moving Forward

In our next piece, we will dig into how we’ve altered our allocations in an attempt to combat incredibly low global interest rates without falling victim to constructing portfolios the default way. Our view is that the 60/40 portfolio of the future will need to look significantly different than it has historically. More on that to come.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. More information about the advisor, and  its investment strategies and objectives, is included in the firm’s Form ADV, which can be obtained, at no charge, by calling (251) 517‐7198. ACA-2007-56.

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We’ve been saying since the middle of last year that the percentage of total returns in fixed income coming from price return wouldn’t likely be the same into the future. Interest rates have nosedived lower following the global pandemic as investors flocked to safety, pushing the prices of safer credits higher. We will be the first to commend you for holding long term Treasuries in 2019- Q2 2020, which would have been a heck of return. As always, we manage our shareholders money looking through the windshield as opposed to the rear-view mirror. Simply put, we don’t believe long dated Treasuries or frankly any fixed income sector is likely to perform as it has the last twenty years. Putting words to actions, we’ve altered our fixed income allocation through both our asset allocation within our FI sleeve but also through the allocation of risk managed strategies allowing us to have less exposure to traditional bonds. Moving forward, one area that is particularly concerning is residential mortgage backed securities.

MBS saved by the Fed?

The agency mortgage backed sector has been temporarily “cured” by the FED during the COVID crisis. In mid-March the Fed pulled out a tool from their GFC toolkit where they vehemently started buying Treasury and MBS products. Following the Fed’s purchase announcement, many buyers knowing the Fed’s actions would stabilize the market started buying. We saw that present across several large investment banks which were able to arb profits by loading up their balance sheets with agency backed mortgages and quickly offloading them to the Fed at hefty premiums. Needless to say, the spreads of mortgages to Treasuries narrowed substantially due to Fed support.

Although mortgages have been a strong performer in 2020, we believe they will likely face future headwinds as the support from federal programs simmer down. There are three specific reasons we’ve moved our fixed income exposure away from mortgages.

#1: Elevated Prepay Risk

Mortgage rates are at their lowest levels… ever. If there is one thing we know even in a pandemic is that Americans enjoy a deal. I don’t think any person would tell you they don’t want more money in their pocket each month and at current rates, many mortgages are in the money to be refinanced. Considering the lack of a prepay penalty on residential mortgages, borrowers will continue to refinance in droves if the numbers make sense, putting more money back in their pockets (Think Quicken Loans aggressive ad campaigns). Imagine being a mortgage investor and continually having to reinvest massive principal prepays at lower interest rates, talk about reinvestment risk!

Source: Vining Sparks IBG, LP

#2: Fed Support

The Federal Reserve announced back in March that it would buy unlimited amounts of Treasuries and agency mortgages to grease the wheels of the credit markets. To say these purchases have been massive is an understatement. Given the widescale Fed purchases in the MBS market, the spread over Treasuries narrowed drastically (leading to price of the security rising higher). Once purchases slow, I expect spreads to widen out when demand shrinks as investors that are actually judged on performance fear the negatively convex return profile.

#3 Primary vs Secondary Spreads are WIDE:

When thinking about mortgage rates, most borrowers only care about what interest rate they can lock in to borrow at; however, that is only part of the mortgage process. The Primary Mortgage rate (rate you can borrow at) is substantially different than the Secondary Mortgage rate which is the interest rate investors receive when purchasing pools of mortgage backed securities. The difference between the rates is the deduction of several fees from the primary mortgage rate which includes servicing fees, guarantee fees (the Fannie Mae or Freddie Mac P&I guarantee ain’t free!),  and securitization fees to name a few.

Currently, the interest rates for mortgage borrowers are at all time lows HOWEVER the spread of primary rates to secondary mortgage rates are substantially wider than their 5 year average. Mortgage lenders can increase borrowing costs to slow down their pipelines due to over demand for refinancing or a potential hesistancy with their current lending criteria.  Most likely the WFH trend caused by COVID has limited the ability for mortgage lenders to handle refinance activity which created a pause on mortgage rates falling lower.  If rates normalized we’d be looking at a ~2.50% 30 year mortgage rate, as one could imagine many would be looking to refinance!

Source: Vining Sparks IBG, LP

As rates have dropped, the price of mortgage securities has gone up. Considering that, most MBS purchases prices regardless of coupon are above Par value ($100). As these securities prepay faster than expected, investors get their principal back quicker than expected which can result in negative yields. The entire mortgage investing world is heavily reliant on expectations of what the borrower will do… investors don’t have any sort of prepay protection on the securities they purchase so holding pools of fast paying mortgages at substantial premiums (>$100) can be quite the doozy. Defaults also result in the same issue as prepays where investors get the principal back at Par, much earlier than expected. If borrowers can’t service their mortgages following the crisis that could be another pain point for mortgage investors.

To sum it all up, we predict major headwinds in the mortgage backed security space moving forward. With the Fed buoying the market with their purchases on top of continued prepay risk it appears to be an environment with limited upside and significant downside. In saying that, we continue to tweak exposure in the portfolios to eliminate mortgage exposure for the time being.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. More information about the advisor, and  its investment strategies and objectives, is included in the firm’s Form ADV, which can be obtained, at no charge, by calling (251) 517‐7198. ACA-20-135

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This is the first of two pieces on some interesting shakeouts we’ve seen the past couple months in the fixed income space. Part One will discuss funds that faced serious difficulties back in March and some insight on why large drawdowns are devastating to achieving long term success. Part Two (to follow soon) will cover the current state of the agency mortgage market, specifically regarding the uptick in prepay speeds and our opinions of implications from the coronavirus on the housing market and mortgage investing.

Markets came into February with some of the tightest spreads for risky assets they’d ever seen. The major repercussion of record low interest rates is that investors are forced to loosen their credit criteria to generate acceptable income and return. As interest rates fell and credit spreads tightened, investors enjoyed appreciating bond prices and very low volatility. As implications from the coronavirus pushed the stock market to one of the deepest and quickest selloffs in history, risky assets quickly repriced as buyers vanished. This escalated into a near total freeze in the credit markets and caused a series of implications.

How leveraged/ credit funds blow up:

Funds invest in Illiquid Assets -> Add Leverage to Increase Yield -> Market drops/ volatility spikes -> Assets pledged as collateral for margin loans suddenly lose value on top of panicking investors sell their shares at any price -> Cash is needed to fund redemptions/ margin calls ->  Fund forced to sell for substantially depressed values -> Happy hedge fund buyers pick up assets for pennies on the dollar.

Funds that fell victim to the Corona crash had some similarities…strong returns and low volatility but complex and illiquid underlying holdings. One actually sported a 5-star Morningstar rating right up until its crash (now a 1-star fund). Most invested in some of the most illiquid credit products: non- agency grade mortgages, student loans, mezzanine grade asset backed securities, credit card receivables, etc. On a good day, these products trade at a wide bid/ ask as it is… in a frozen market (remember the investment grade bond fund LQD was down 20% at one time) there were no buyers.

So the big question is why didn’t these funds get the same type of support we saw in other fixed income sectors? Although the Fed shot a bazooka at the market from a liquidity perspective, the actions weren’t as meaningful in the lowest quality credit products. The Fed’s activities were designed to lubricate a sputtering economic engine and protect the largest portions of the economy and credit markets… government debt, corporate debt and the housing market. Unfortunately for the riskiest investments, the moral hazard of a bailout thus far has been too high.

For example, the cash flows owned by investors in student loan backed securities have temporarily ceased… the same with collateral tied to machinery, commercial properties, etc. Remember most of the assets packaged into these types of securities have high interest rate due to the quality of borrower or business… their rainy-day fund was small or negligible to begin with. As uncertainties crept into these businesses and the likelihood of being able to make future P&I payments quickly decreased, the required return investors needed shot up drastically. We also believe the narrower audience of potential buyers further exacerbated the lack of liquidity.

In managing portfolios, we have emphasized the importance of avoiding large drawdowns. In the case above, the damage is likely irreversible. Both funds were both down >45% in a matter of days; the time/ returns necessary to make up those size losses are very high and remember, these aren’t equity funds that have actual growth potential. This brings us to the closing point… the volatility tax associated with large drawdowns and how devastating it is on long term investing success.

Risk of losing your money (drawdown risk) strikes quickly and without warning. It can be hard to swallow and should be avoided because of the math:

Turning expected returns into actual compounded returns starts with lowering exposure to large drawdowns. While low interest rates have encouraged some to trade Treasuries for more exotic credits, it’s important to understand what’s in a portfolio and what risks it may introduce. Especially if its role is to provide a buffer to stock market volatility.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment and tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. More information about the advisor, and  its investment strategies and objectives, is included in the firm’s Form ADV, which can be obtained, at no charge, by calling (251) 517‐7198. ACA-20-128.

The post What Bonds Do You Own? appeared first on Aptus Capital Advisors.

As many market participants predicted, the Fed would have limited effectiveness in using their monetary policy tool (setting short end interest rates) in the event of an economic downturn. We came into a crisis (COVID pandemic) at the lowest Fed Funds Rate ever. Essentially this forced the hand of the Fed to implement supplemental actions in addition to utilizing their 2008 playbook.

We could spend years studying (debating) the Fed’s place in our economy as well as the intricacies of each measure taken during the COVID pandemic. There are some great sources available (shoot us a message if you’d like more resources, also see the end of the post). For time purposes we will summarize the Fed’s response to the crisis and our opinions on most significant. Each facility and Fed action is very detailed on the specific amount of funds, dates available, eligibility criteria, etc. Again, if you have questions feel free to reach out.

The Federal Reserve “Fed” is responsible for setting monetary policy and being a lender of last resort. During times of crisis, private lenders pull their capital from markets (or hike rates substantially to compensate for higher credit risks). This lack of funding and liquidity can be detrimental to the global economy. Private market lending works most of the time but during times of crisis liquidity dries up and forces the Fed to steps in and “oil the engine” by injecting cash into the market (giving loans to borrowers when no one else will).

Source: Goldman Sachs, as of 04.30.2020

Quick side note on SPVs The Fed can’t legally take many of the policy actions (at least directly) so they commit funds to a Special Purpose Vehicle “SPV” on a recourse basis and leverage the funds based on their specific mandate. #1 the Fed can’t take losses #2 the Fed can’t print money. The Department of the Treasury uses the Exchange Stabilization Fund to make the initial equity investment in the SPV in connection with each facility. The Fed then uses the funds from the Treasury in order to lend as they are in a better position to act quickly. Keep this in mind when we mention SPVs.

Fed Actions

March 15^th: the Fed stated they would purchase $500M Treasuries and $200M government-backed mortgages to increase liquidity into the banking system.
Post March 15^th Update: This was later increased essentially giving the Fed the ability to purchase an infinite number of Treasuries and MBS. For reference, between March 16 and April 16, the Fed bought Treasury and mortgage securities at a pace of nearly $79 billion a day. By comparison, it bought about $85 billion a month between 2012 and 2014.

Source: Federal Reserve Bank of St. Louis, as of 04.30.2020

March 17^th: The return of the Commercial Paper Funding Facility (CPFF). This facility was used back in the 2008 crisis and officially states we are in a crisis (invoking 13(3) emergency) and officially initiate SPVs. Essentially this facility allows corporations to access liquidity via the commercial paper market where the Fed serves as a lender. Many companies use this short-term borrowing mechanism to meet near term liabilities. This fund was necessary to sure up near-term corporate solvency.

The next action was the Primary Dealer Credit Facility. This action offers liquidity to Primary dealers which have a special position in the market to provide bids on all U.S. Treasury issuance which ensure the Treasury auctions succeed. The facility increased the collateral types the Primary Dealers could pledge with the Fed, easing liquidity concerns.

March 18^th: Money Market Mutual Fund Liquidity Facility (MMLF): Basically, the Fed will take money market funds as collateral for loans to financial institutions in order to handle liquidity needs (money market funds are a pivotal part of household liquidity). The interesting part here is that the loans are non- recourse, meaning all the Fed has rights to is the collateral in the event of impairment or default. This means banking participants are not exposed to credit or market risk from the subsequent purchase of money market assets that are in turn pledge at the Fed. The facility also allowed the municipal debt 1 year and in as collateral.
Post March 18^th Update: The Fed further extended the municipal maturity eligibility to inside three years.

March 23^rd: Term Asset- Backed Securities Loan Facility (TALF). This is another facility geared at helping ease liquidity for corporations. Here is list is of the types of eligible collateral: auto loans/ leases; student loans; credit card receivable; equipment loans; floorplan loans; SBA guaranteed loans to name a few. Again, these loans are non- resource.

Arguably the most important of the facilities is the Primary and Secondary Credit Facilities. This was a new measure taken by the Fed allowing them to purchase corporate bonds. The main desire of these facilities was to lower credit spreads over the risk-free rate (since they can’t take rates any government rates lower).

Primary Market Corporate Credit Facility (PMCCF): Serves as a funding backstop for corporate debt issued by eligible issuers. This facility will allow the SPV to purchase qualifying bonds directly from eligible issuers and provide loans to eligible issuers. Additionally, there are limits on how much of the outstanding debt the SPV can purchase based on credit ratings.

Secondary Market Corporate Credit Facility (SMCCF): By way of SPVs this facility will purchase in the secondary market corporate debt issued by eligible issuers. The SPV can purchase corporate bonds in the secondary market as well as eligible corporate bonds in the form of ETFs. This does include ETFs with exposure to U.S. high-yield corporate bonds.

Highlights of Criterion for Inclusion in the Corporate Credit Facilities: Source:https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm

• The issuer was rated at least BBB-/Baa3 as of March 22, 2020, by a major nationally recognized statistical rating organization (“NRSRO”). If rated by multiple major NRSROs, the issuer must be rated at least BBB-/Baa3 by two or more NRSROs as of March 22, 2020.
• This was Updated: to include Issuers that were rated at least BBB-/Baa3 as of March 22, 2020, but subsequently downgraded, must be rated at least BB-/Ba3 at the time the Facility makes a purchase.
• Maturity of four years or less for PMCCF inclusion
• Maturity of five years or less for SMCCF inclusion

Main Street Lending Program (MSLNF)

The above facilities are mostly geared towards financial institutions and large publicily traded corporations. This part of the blog will touch on is the MainStreet program. This program gives U.S. Banks access to capital to originate loans for private businesses. This facility is designed to get mid- sized private businesses access to capital at favorable rates with minimal risk to the banks. The eligible lenders will be required to retain 5% of the loan with the remaining 95% sold to the Main Street facility. Companies in turn agree to some terms such as reasonable effort to maintain payroll/ workers, follow certain compensation and capital allocation restrictions, maintain EBITDA leverage conditions and cannot use the proceeds to pay down other loan balances. Also, borrowers can’t double dip between this facility and others if they are eligible to multiple. Overall, we believe the goal of this facility is to keep employees from sizable private business on the payroll while keeping these companies floated until the economy works through the crisis.
Update: The Fed has expanded the MSLNF offering a few different set of loan options as well as increased the business size eligible.

Paycheck Protection Program Liqudity Facility (PPPLF)

The Paycheck Protection Program (PPP) is being implemented by the Small Business Administation and was one of the core provisions of the CARES act passes March 27th. The facility grants a pathway to funds for eligible lenders to make loans to small businesses to help covers costs like payroll, rent and utilities. We consider two parts of the PPP program to stand out. First, the loans are potentially forgivable if the proceeds are used to pay eligible expenses. The second is to whom the funds are available. The SBA website cites that “current economic uncertainty makes this loan request necessary to support the ongoing operations of the applicant.” We are curious on how strict the SBA will be on potential abusers and how much leeway they will have to expand the size of the facility (already been increased once).

A recent survey done by LendingTree found that only 5% of business owners have received a PPP loan.

Source: Lending Tree as of 04.31.2020

To summarize: This post covers several actions the Fed has taken thus far to help support the markets and provide liquidity to financial institutions, corporations, private businesses and municipalities facing difficult times. All of these facilites are designed to keep different segments of the economy afloat until things normalize. In our opinion, it was impossible to prepare for the ramifications of businesses being shut down due to the length of shutdown/ stay at home orders. We believe programs were necessary to keep the economy afloat but also acknowledge the Fed has opened new doors with the policies. Specifically, the buying of corporate bonds (especially below investment grade rated) has and will likely continue to create major support in the credit markets. It will be interesting to see how this plays out and the potential moral hazard created as well as potential consequences of owning impaired assets. The Fed Put appears to be alive and well… for now at least.

Sources:

https://www.lendingtree.com/business/just-5-percent-small-businesses-received-ppp-money/

https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.htm

https://www.sba.gov/funding-programs/loans/coronavirus-relief-options/paycheck-protection-program

https://nathantankus.substack.com/

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-20-110

The post The Fed Bazooka appeared first on Aptus Capital Advisors.

Quick review

Treasury rates have free fallen lower over the past year, especially in 2020. The fear of the aftershock of the COVID-19 pandemic on the global economy led the Fed to enact two separate emergency rate cuts bringing the Fed Fund rate to 0.00-0.25% in March. The basis point changes of several UST tenors are simply amazing. Throughout the pandemic we have seen a massive flock to safety (and liquidity), cratering yields on U.S. risk free assets up and down the curve.

Source: Vining Sparks IBG, LP

Unprecedented volatility in March across the Fixed Income sector can be seen in the MOVE index. MOVE is essentially the VIX for Treasury Bonds. We had a monumental rise up and then back down as the Fed took action. The Fed action was to the tune of growing their balance sheet by >60% in less than a month (see second chart below).

Source: Bloomberg LP

Source: The Federal Reserve/ Aptus Analytics

Agency/ Treasuries

Source: Trading View

First off, we will start with the Barclays Aggregate (Ticker: AGG). The AGG’s portfolio is allocated ~70% to government back securities (U.S. Treasuries, Agencies, Mortgages) and 30% investment grade corporate securities. This is one of the most benchmarked ETFs and nearly every portfolio has some sort of exposure. The eye opener here is the 9-business day performance of the AGG between March 6^th and March 18^th where the AGG dropped nearly –10%. Only a few times in history have we seen the AGG drop this aggressively and this is by far the quickest drop of such magnitude.

The cause of the drop was essentially a massive liquidity crunch where the general market saw exponentially more sellers than buyers. The fact that there were no buyers simply means no bids and in turn no liquidity. This leads to wider spreads and lower prices until someone is willing to step in and offer liquidity. The fuel to the fire was margins calls from levered funds which caused a massive need for liquidity, forcing holders to sell at any price. Many times these safe haven assets are the first to get sold as they have incurred the least damage. The “V” shaped recovery seen since March 18^th can mostly be attributed to the Fed’s buying programs.

Investment Grade Corporates

Source: Trading View

One can imagine the fate of Investment grade bonds (Ticker: LQD) after seeing the melt down of the AGG mentioned above. Nearly a -22% decline in market price from March 6^th– March 18^th. Again, one of fastest drops in price we have ever seen as investors feared massive impairments on companies’ financial situations (and likely to come downgrades) as a result of the pandemic. Fear and the need for liquidity created an environment where no one wanted to be stuck holding the bag!

Source: Deutsche Bank

An increase in lower quality issuers (increase in BBB/ Baa rated debt) since the housing crisis has driven growth of the investment grade market. As ratings get closer to junk, the universe of potential holders get lower and lower. We expect more forced selling as issuers are downgraded and typical large institutional holders like pension funds, insurance funds and other regulated entities not only won’t be able purchase but in some mandated instances will be forced to sell. It will be interesting to see how quick the rating agencies will re-rating companies’ debt given their ability to repay could be impaired considering the pandemic.

High Yield

Source: Trading View

High Yield bonds (Ticker: HYG) also faced a difficult environment with a collapse in the prices of junk bonds as both the stock market and oil prices collapsed. As fear surmounted in the stock market, higher beta debt (less credit worthy borrowers) became even riskier as high uncertainty of business sustainability quickly became a reality. Needless to say, holders of the junk rated debt manically sold at whatever price they could.

Source: Factset

All sectors within the High Yield space have seen spreads widen significantly with energy spreads unsurprisingly being the worst performers. Nearly all sectors saw spread to Treasuries double. We believe the big question here is to whether the underlying borrowers will be able to service their debts given the current business environment, specifically energy companies with significant leverage and falling oil prices.

Emerging Market Debt

Source: Trading View

Emerging Market debt (Ticker: EMB) was one of the better performing fixed income classes in 2019. It has gotten smoked through the pandemic. With most EM markets reliant on energy and functioning supply chains it comes to no surprise on the poor performance. The strong $USD continues to devastate these economies from a trade and local currency perspective. We see multiple major headwinds on EM economies through this difficult time.

Municipal Bonds

Source: Trading View

Municipal bond prices historically have shown a very low correlation to equity prices. Unfortunately, in a fire sale, no asset classes are safe. As investors rushed to cash we saw significant pressure on munis throughout March. Highlighted above is Nuveen’s levered municipal closed end fund (ticker: NVG) which saw enormous headwinds from both margin calls internally as well as investors dumping the fund seeking cash (NVG was down -26% from March 6- March 18). The fund is down -18% YTD.

We believe municipalities will require more government intervention to fare the aftermath of the Covid pandemic given the sure reduction in taxes this year. The other consideration is that municipalities and states actually have to have a balanced budget and can’t print money like the Treasury/ Fed combo. The Fed has come in and offered some support to the municipal market helping support prices. We have seen a small recovery in prices and substantially less rampant price dislocations however leveraged funds like NVG are still licking their wounds.

Source: Trading View

Agency Mortgages

The most supported asset classes by the Fed behind U.S. Treasuries has been mortgages (Ticker: MBB). It is hard for us to wrap our heads around owning mortgages right now given the current economic backdrop. In our opinion we could see a double whammy on mortgage products: refi risk given current interest rates (AKA prepayment risk) and risk of borrower default leading to a loss of premium paid for the security. As mortgage prices have risen materially from lower interest rates and tighter spreads (thanks to the Fed), nearly every purchase regardless of the coupon will come at a premium dollar price. If a borrower refinances or sells their home, the loan pays off at $100 to the bond holder (remember no pre-pay penalty to refinance a mortgage). If the borrower defaults, the loan is still paid off at $100 thanks to the Fannie Mae / Freddie Macs guarantee. I’ll let you guess who guarantees Fannie and Freddie’s balance sheet. As these bonds are priced at hefty premiums, we see significant risk in the above factors while very little upside at present. Negative convexity at its finest!

Levered Loan/Credit

To wrap everything up I wanted to spend a little time going over one of the more leveraged and risky credit products in the market. I will highlight Blackstone’s Strategic Credit Fund (Ticker BGB).

Source: Trading View

Per the prospectus, the fund primarily invests in the loans and other fixed income instruments including first- and second-lien secured loans and high-yield corporate bonds of different maturities.  There are two parts to the story here but the real kicker here… leverage! The fund incurs leverage of ~33% of its managed assets by borrowing via a credit facility. This type of fund (along with other leveraged vehicles) utilizes the reverse repo markets where they pledge the securities they own as collateral to secure short-term financing. This works well until liquidity vanishes and the value of the collateral falls off a cliff leading to a margin call. If the fund doesn’t have the cash, it must raise cash… this leads to selling at the bottom and realizing massive losses. The other significant factor here was the redemptions coming from a client dash to cash. This rings true for any leveraged vehicle but especially something involving less liquid, lower rated securities. What we saw here was a straight up fire sale.

Wrapping all this up, one can easily see the Fed’s actions have helped bring some equilibrium back to parts of the fixed income markets. Like one would expect, the risker, leveraged classes were the most volatile through the initial COVID-19 phase. We’ve always said, when a product yields is 5-7% in a <1% 10 year Treasury environment, there is typically risk involved.

We will have a follow up this post to cover some of the specific actions taken by the Fed coming soon!

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward looking statements cannot be guaranteed.

This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy. Investing involves risk. Principal loss is possible.

Advisory services offered through Aptus Capital Advisors, LLC, a Registered Investment Adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level or skill or training. More information about the advisor, its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. Aptus Capital Advisors, LLC is headquartered in Fairhope, Alabama. ACA-20-108.

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